Expert answer:BUS 4480 WK7: Pick one
Expert answer:Please choose ONE of the five topics below and provide a 1-2 page discussion. Support your stance with information in the reading material and one peer reviewed academic journal article.In text reference and references are required. Why do international businesses need to use the foreign exchange market? What are the risks associated with currency speculation? (Chapter 10) What is the relationship between interest rates and exchange rates? How might investor psychology influence exchange rates? (Chapter 10) Compare/ contrast the strengths and weaknesses of a currency board arrangement (Chapter 11) Present an argument for either fixed or floating exchange rates. Support your stance.
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Global Business Today 10e
by Charles W.L. Hill
and G. Tomas M. Hult
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
Source: © ICP-Tech/incamerastock/Alamy Stock Photo
The Global Monetary System
Chapter 10: The Foreign Exchange Market
Learning Objectives
LO 10-1
Describe the functions of the foreign exchange market.
LO 10-2
Understand what is meant by spot exchange rates.
LO 10-3
Recognize the role that forward exchange rates play
in insuring against foreign
exchange risk.
LO 10-4
Understand the different theories explaining how
currency exchange rates are
determined and their
relative merits.
LO 10-5
LO 10-6
Identify the merits of different approaches toward
exchange rate forecasting.
Compare and contrast the differences among
translation, transaction, and
economic exposure, and
explain the
implications for management practice.
Opening Case:
Apple’s Earnings Hit by Strong Dollar
▪ Apple reported in January 2016 that strong U.S. dollar had
cost company nearly $5 billion in revenue
▪ Apple gets 66% of its revenue from outside of U.S.
▪ Apple has been buying currency forward to hedge against
future increases but dollar has been appreciating faster
▪ Apple has had to implement price increases in some markets
▪ Other major technology companies having same issues
▪ Dollar now stronger
✓ U.S. economy stronger so attractive for foreign capital
✓ European and Japanese governments have lowered interest rates
✓ Developing nations have downward pressures on their currencies
Introduction
▪ The foreign exchange market is a market for
converting the currency of one country into that of
another country
▪ An exchange rate is the rate at which one currency is
converted into another
The Functions of the Foreign Exchange Market 1 of 6
1. Enables the conversion of the currency of one
country into the currency of another
2. Provides some insurance against foreign exchange
risk: the adverse consequences of unpredictable
changes in exchange rates
The Functions of the Foreign Exchange Market 2 of 6
Currency Conversion
✓ To convert export receipts, income received from foreign
investments, or income received from licensing
agreements
✓ To pay a foreign company for products or services
✓ To invest spare cash for short terms in money markets
✓ For currency speculation: the short-term movement of
funds from one currency to another in the hopes of
profiting from shifts in exchange rates
▪ Carry trade borrows one currency where interest rates are low and
invests these in another currency where interest rates are high
Currency Exchange
Source: © Ed Brown/Alamy Stock Photo
Every time tourists change
money in a foreign country
they are participating in the
foreign exchange market.
Should Countries Be Free to Set Currency Policy?
Exchange rates are critically important in the global economy.
They affect the price of every country’s imports and exports,
companies’ foreign direct investment, and—directly or
indirectly— people’s spending behaviors. In recent years,
disagreements among countries over exchange rates have
become much more widespread. Some government officials and
analysts even suggest that there is a “currency war” among
certain countries. The main issue is whether or not some
countries are using exchange rate policies to undermine free
currency markets and whether they intentionally, in essence,
devalue their currency to gain a trade advantage at the expense
of other countries. A weaker currency makes exports
inexpensive (or at least cheaper) to foreigners, which can lead
to higher exports and job creation in the export sector.
Source: Nelson, R. M., “Current Debates over Exchange Rates: Overview and Issues for Congress,” Congressional Research Service,
November 12, 2013.
The Functions of the Foreign Exchange Market 3 of 6
Insuring Against Foreign Exchange Risk
✓ The foreign exchange market can provide insurance
against foreign exchange risk: the possibility that
unpredicted changes in future exchange rates will have
adverse consequences for the firm
▪
A firm that protects itself against foreign exchange risk is hedging
✓ The market performs this function using
1.
2.
3.
Spot exchange rates
Forward exchange rates
Currency swaps
The Functions of the Foreign Exchange Market 4 of 6
Insuring Against Foreign Exchange Risk continued
✓ Spot Exchange Rates
▪ Rate at which a foreign exchange dealer converts one currency
into another currency on a particular day
▪ Determined by the interaction between supply and demand
▪ Changes continually
The Functions of the Foreign Exchange Market 5 of 6
Insuring Against Foreign Exchange Risk continued
✓ Forward Exchange Rates
▪ The exchange rate governing a forward exchange
▪ A forward exchange occurs when two parties agree to exchange
currency and execute the deal at some specific date in the future
▪ Forward exchange rates are typically quoted for 30, 90, or 180
days into the future
▪ Can sometimes work against a company
The Functions of the Foreign Exchange Market 6 of 6
Insuring Against Foreign Exchange Risk continued
✓ Currency Swaps
▪ Simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates
▪ Swaps are used when it is desirable to move out of one currency
into another for a limited period without incurring foreign
exchange rate risk
Should Currency Speculation be Allowed?
Currency speculation involves the short-term movement of funds from one
currency to another in the hopes of profiting from shifts in exchange rates.
Sometimes this speculation is done as what is called a carry trade. In effect, it
can be argued that currency speculation tactics may have a strong negative
effect on some countries’ economic foundation (e.g., Iceland, Thailand). For
years, Iceland was a respected country for its unmatchable standards of living.
The 2008 economic turmoil threw the island nation’s currency off the cliff.
The hedge funds closed in, and the government had to try to fight off the
predators. Several years later, Iceland is still feeling the effect of these
currency woes, albeit the country is now in recovery mode and progressing in
a positive direction. But the issue remains that large-scale currency
speculation has the potential to adversely affect global markets. So, should
currency speculation be allowed?
Source: A. Jung and C. Pauly, “Currency Woes: Crashing the Party of Icelandic Prosperity,” Spiegel Online International, April 10,
2008.
The Nature of the Foreign Exchange Market
The foreign exchange market is a global network of
banks, brokers, and foreign exchange dealers
connected by electronic communications systems
✓ The market is always open somewhere in the world
✓ If exchange rates quoted in different markets were not
essentially the same, there would be an opportunity for
arbitrage: the process of buying a currency low and selling
it high
✓ Most transactions involve U.S. dollars on one side
✓ The U.S. dollar is a vehicle currency
Economic Theories of Exchange Rate Determination
1 of 9
Three factors have an important impact on future
exchange rate movements
1. A country’s price inflation
2. A country’s interest rate
3. Market psychology
Economic Theories of Exchange Rate Determination
2 of 9
Prices and Exchange Rates
✓ The law of one price
▪ In competitive markets free of transportation costs and barriers to
trade, identical products sold in different countries must sell for
the same price when price is expressed in terms of the same
currency
✓ Purchasing power parity (PPP)
▪ Given relatively efficient markets (markets in which few
impediments to international trade and investment exist) the price
of a “basket of goods” should be roughly equivalent in each
country
Economic Theories of Exchange Rate Determination
3 of 9
Prices and Exchange Rates continued
✓ Purchasing Power Parity continued
▪ PPP predicts that changes in relative prices will result in changes in
exchange rates
▪ When inflation is relatively high, a currency should depreciate
Economic Theories of Exchange Rate Determination
4 of 9
Prices and Exchange Rates continued
✓ Money Supply and Price Inflation
▪ If we can predict inflation rates, we can predict how a currency’s
value might change
▪ The growth of a country’s money supply determines its likely
future inflation rate
▪ When the growth in the money supply is greater than the growth
in output, inflation will occur
Effects of Inflation
Women shop at an
outdoor market in
La Paz, Bolivia.
Bolivia’s inflation
rate is much lower
today than it was in
1985 but must be
carefully monitored.
Source: © Noah Friedman-Rudovsky/Bloomberg/Getty Images
Economic Theories of Exchange Rate Determination
5 of 9
Prices and Exchange Rates continued
✓ Empirical Tests of PPP Theory
▪
Indicates that it is not completely accurate in estimating exchange
rate changes in the short run, but is relatively accurate in the long
run
▪ The purchasing power parity puzzle
▪ Assumes away transportation costs and barriers to trade
What about the Starbucks Index, a Good Idea?
To test the Big Mac index, which applies the purchasing power parity (PPP)
theory using the price of a Big Mac in various markets to determine the
equilibrium value of the foreign currency, The Economist established a
Starbucks index in 2004. Like the Big Mac, a cup of Starbucks coffee can be
found in many foreign markets and can be seen as a proxy for a basket of
goods. The results of the Starbucks index followed the Big Mac index in most
markets, except in Asia, where the former indicated that the dollar was at
parity with the Chinese yuan. The Big Mac index suggested that the yuan was
heavily undervalued. Neither of these consumer items is a good proxy for a
basket of goods, but comparing their relative prices with exchange rates is an
interesting and playful approach to quickly grasping how under- or
overvalued the foreign currency is against the dollar. This obviously does not
take into account whether you think a McDonald’s Big Mac or a Starbucks cup
of coffee is overpriced or relatively cheap where you live! What would be a
good product, sold worldwide, that can replace the Big Mac and Starbucks
indices?
Economic Theories of Exchange Rate Determination
6 of 9
Interest Rates and Exchange Rates
• The Fisher Effect states that a country’s nominal interest
rate (i) is the sum of the required real rate of interest (r )
and the expected rate of inflation over the period for
which the funds are to be lent (I)
• In other words, i = r + I
• So, if the real interest rate is the same everywhere, any
difference in interest rates between countries reflects
differing expectations about inflation rates
Economic Theories of Exchange Rate Determination
7 of 9
Interest Rates and Exchange Rates continued
✓ International Fisher Effect suggests that for any two
countries, the spot exchange rate should change in an
equal amount but in the opposite direction to the
difference in nominal interest rates between the two
countries
▪ In other words:
(S1 – S2) / S2 x 100 = i $ – i ¥
where i $ and i ¥ are the respective nominal interest rates in two
countries (in this case the U.S. and Japan), S1 is the spot exchange
rate at the beginning of the period and S2 is the spot exchange
rate at the end of the period
Economic Theories of Exchange Rate Determination
8 of 9
Investor Psychology and the Bandwagon Effects
• Bandwagon effect occurs when expectations on the part
of traders turn into self-fulfilling prophecies, and traders
join the bandwagon and move exchange rates based on
group expectations
• Governmental intervention can prevent the bandwagon from
starting, but is not always effective
Economic Theories of Exchange Rate Determination
9 of 9
Summary of Exchange Rate Theories
✓ Relative monetary growth, relative inflation rates, and
nominal interest rate differentials are all moderately good
predictors of long-run changes in exchange rates, but poor
predictors of short term changes
✓ So, international businesses should pay attention to
countries’ differing monetary growth, inflation, and
interest rates
Exchange Rate Forecasting 1 of 3
▪ The Efficient Market School
✓ Efficient market is one in which prices reflect all available
information
✓ Forward exchange rates are the best predictors of future
spot exchange rates
✓ Investing in forecasting services is a waste of money
Exchange Rate Forecasting 2 of 3
▪ The Inefficient Market School
✓ Inefficient market is one in which prices do not reflect all
available information
✓ Forward exchange rates are not the best predictors of
future spot exchange rates
✓ Companies should invest in forecasting services
Did You Know?
Did you know that the
U.S. dollar has been
one of the strongest
currencies in the world
since the great
recession of 2008–
2009?
Click to play video
Exchange Rate Forecasting 3 of 3
Approaches to Forecasting
1.
Fundamental analysis
▪
2.
Draws upon economic factors like interest rates, monetary
policy, inflation rates, or balance of payments information to
predict exchange rates
Technical analysis
▪ Uses price and volume data to determine past trends that are
expected to continue
▪
Many economists skeptical of technical analysis
Currency Convertibility 1 of 2
Various types of currencies
✓ Freely convertible: both residents and non-residents can
purchase unlimited amounts of foreign currency with the
domestic currency
✓ Externally convertible: only non-residents can convert
their holdings of domestic currency into a foreign currency
✓ Nonconvertible: both residents and non-residents are
prohibited from converting their holdings of domestic
currency into a foreign currency
Currency Convertibility 2 of 2
• The main reason is to preserve foreign exchange
reserves and prevent capital flight: when residents
and nonresidents rush to convert their holdings of
domestic currency into a foreign currency
• In the case of a nonconvertible currency, firms may
turn to countertrade (barter like agreements by
which goods and services can be traded for other
goods and services) to facilitate international trade
Focus on Managerial Implications 1 of 4
FOREIGN EXCHANGE RATE RISK
Firms must understand the influence of exchange rates
on the profitability of trade and investment deals
✓ Transaction exposure
▪ The extent to which the income from individual transactions
is affected by fluctuations in foreign exchange values
✓ Translation exposure
▪ The impact of currency exchange rate changes on the
reported financial statements of a company
✓ Economic exposure
▪ The extent to which a firm’s future international earning
power is affected by changes in exchange rates
Focus on Managerial Implications 2 of 4
Reducing Translation and Transaction Exposure
✓ Buy forward
✓ Use swaps
✓ Lead Strategy
▪ Collect foreign currency receivables early when a foreign currency
is expected to depreciate
▪ Paying foreign currency payables before they are due when a
currency is expected to appreciate
✓ Lag Strategy
▪ Delay collection of foreign currency receivables if that currency is
expected to appreciate
▪ Delay payables if the currency is expected to depreciate
Focus on Managerial Implications 3 of 4
Reducing Economic Exposure
✓ Firms need to distribute productive assets to various
locations to avoid long-term financial problems
associated with changes in exchange rates
Focus on Managerial Implications 4 of 4
Other Steps for Managing Risk
1. Establish central control to protect resources efficiently
and ensure that each subunit adopts the correct mix of
tactics and strategies
2. Distinguish between transaction and translation exposure
on the one hand, and economic exposure on the other
hand
3. Attempt to forecast future exchange rates
4. Establish good reporting systems so the central finance
function can regularly monitor the firm’s exposure
position
5. Produce monthly foreign exchange exposure reports
Summary
In this chapter we have
✓ Described the functions of the foreign exchange market.
✓ Understood what is meant by spot exchange rates.
✓ Recognized the role that forward exchange rates play in
insuring against foreign exchange risk.
✓ Understood the different theories explaining how currency
exchange rates are determined and their relative merits.
✓ Identified the merits of different approaches toward
exchange rate forecasting.
✓ Compared and contrasted the differences among
translation, transaction, and economic exposure, and what
managers can do to manage each type of exposure.
Global Business Today 10e
by Charles W.L. Hill
and G. Tomas M. Hult
©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
© Dmitry Kalinovsky/Shutterstock.com
The Global Monetary System
Chapter 11: The International Monetary System
Learning Objectives
LO 11-1
Describe the historical development of the modern global
monetary system.
LO 11-2
Explain the role played by the World Bank and the IMF in
international monetary system.
the
LO 11-3
a
LO 11-4
why
LO 11-5
the
LO 11-6
Compare and contrast the differences between a fixed and
floating exchange rate system.
Identify exchange rate regimes used in the world today and
countries adopt different exchange rate regimes.
Understand the debate surrounding the role of the IMF in
management of financial crises.
Explain the implications of the global monetary system for
management practice.
Opening Case:
China’s Exchange Rate Regime
▪ U.S. politicians claim China actively manipulates the
yuan to keep its value low against the dollar to boost
Chinese exports
▪ Yuan devalued in 1980s to improve competitiveness
of Chinese exports
▪ Pressure to let currency appreciate as exports grew
▪ In 2005, country adopted managed floating exchange
rate system
✓ Allowed for appreciation of yuan
Introduction 1 of 2
▪ The international monetary system is the institutional
arrangement that govern exchange rates
• Recall that the foreign exchange market is the primary institution for
determining exchange rates
▪ A floating exchange rate system exists where the foreign
exchange market determines the relative value of a currency
▪ A pegged exchange rate system exists when the value of a
currency is fixed to a reference country and then the
exchange rate between that currency and other currencies is
determined by the reference currency exchange rate
Introduction 2 of 2
▪ A managed float or dirty float exists when the value of a
currency is determined by market forces, but with central
bank intervention if it depreciates too rapidly against an
important reference currency
▪ With a fixed exchange rate system countries fix their
currencies against each other at a mutually agreed upon value
✓ Prior to the introduction of the euro, some European Union countries
operated with fixed exchange rates within the context of the European
Monetary System (EMS)
The Gold Standard 1 of 4
• The origin of the gold standard dates back to ancient
times when gold coins were a medium of exchange,
unit of account, and store of value
• To facilitate trade, a system was developed so that
payment could be made in paper currency that could
then be converted to gold at a fixed rate of exchange
The Gold Standard 2 of 4
Mechanics of the Gold Standard
✓ The gold standard is the practice of pegging currencies to
gold and guaranteeing convertibility
▪ Under the gold standard one U.S. dollar was defined as equivalent
to 23 …
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